Friday, June 16, 2017

The Long-Term Price of Oil Is ...

What's the right way to think about the long-term price of oil?

This question consumes the industry -- and markets -- no matter what prices are on any given day. Back in 2000, when mega-mergers formed giants like Exxon Mobil Corp., it was typical to plug roughly $20 a barrel into valuation models. Only a few years ago, we were being told that "$100 a barrel is becoming the new $20". One crash later, no oil major's slide deck is complete without a pledge to fund itself at $55 or less.

Take a look at the oil futures curve just prior to the crash and in several more recent periods and you can see that, for all the movement in daily prices, longer term prices seem pretty anchored around that level:

Another New Normal

Long-term oil futures have collapsed by almost half and are anchored around $55 a barrel

Why that level? The likeliest explanation is that it appears to be the trigger point for U.S. shale producers to boost drilling and fracking, raising supply relatively quickly and thereby keeping a lid on prices. Meanwhile, the rest of the industry has had to squeeze costs to remain competitive with these Texas upstarts. The previous spell of cost inflation behind that "$100 is the new $20" comment now works the other way.

And because shale's productivity owes more to inputs of capital, technology and innovation -- like manufacturing, in other words -- than traditional advantages of political access to territory, it represents a sea change in oil's economics (see this and this), upending the old paradigm centered on OPEC.

But oil is a weird market.

Presenting BP Plc's latest edition of its annual Statistical Review of World Energy earlier this week, the oil major's chief economist, Spencer Dale, raised an interesting point about the role of oil-exporting nations in an age of relative oil abundance:

If you are a very large oil producer, you can run very significant fiscal deficits for two, three, four, five years, and that is perfectly fine for you to do that ... You cannot run very large fiscal deficits forever. And therefore, in the longer run, I think we need to think not only about what the cost of extracting oil out of the ground is, you also have to think about the nature of the economies of those major oil producers. And for them, I do not see many of those major oil producers with economies which work anywhere near $50, let alone below $50.

In an interview in New York the next day, he elaborated:

One's natural instinct as an economist is to say: Well, I know how to price anything in the long run. I work out what the cost of producing it is; I put a return on capital in it; that gives me a markup: That's the long-run price.

In oil's case, however, those big exporting countries present a problem because, as Dale says, most of them require oil prices far above $50 to make their economies work over the long term (see this). Even Saudi Arabia, which was smart enough to sock away billions in the boom years, can't withstand prices at this level for long.

About a decade ago, at the height of the peak oil frenzy, this need on the part of OPEC countries was used by some to justify ever-higher price expectations. Under this thinking, OPEC had most of the oil reserves, and its members' one-trick economies needed $100-plus prices to function; ergo, oil had to be priced at that level.

I mean, come on. That's like me going to my boss and saying, "I need to be paid millions because, you know, I've got a certain lifestyle to maintain." They'd find another, cheaper journalist or make do with none at all. Oil consumers did the same thing.

The point isn't that OPEC's needs set prices in that way. It's more that, with its members still supplying about 40 percent of the world's oil, their economic weaknesses represent a risk to seeing prices as being in inexorable decline from here. Consider, if U.S. oil companies aren't economic, they can try to cut costs and, even if unsuccessful, the worst that happens is a trip to bankruptcy court. In an oil-dependent economy, governments must embark on radical and potentially destabilizing reform -- see Saudi Arabia -- or can, as in Venezuela's case, flirt with outright collapse.

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